Hamish McRae: Switch into equities gives me a high

Monday 14 January 2013 11:45 BST

Share markets here and elsewhere are nudging new “highs”; yet the economic outlook is at best mediocre. Is this a disconnect, or might the recovery in shares and other asset prices help sustain an increase in real demand?

Since last summer the main share markets everywhere have perked up — even in the distressed countries of fringe Europe. You can interpret that in a number of ways. It could be largely a function of central bank pump-priming: the wall of money has to go somewhere. It might be a growing disenchantment with the negative real yields on sovereign debt, or at least the debt of the so-called safe-haven countries. But it might be that share-buyers are prepared to look through the probability of a dark spring and see some sunlit uplands ahead.

At any rate the big switch out of bonds and into equities seems to have begun. We cannot know whether it will be sustained and here in the UK it certainly cuts an odd contrast with the stories of a “triple-dip” recession. Compared with other major markets, UK shares look relatively cheap — a prospective price/earnings ratio of around 12, against the low teens in the US and Germany. But they are not absurdly cheap as they have been at the bottom of most previous economic cycles.

Still, the fact that share prices have recovered must have some impact on confidence and hence on demand. There is one direct effect: a rise in share prices reduces pension-fund deficits. For companies saddled with under-funded pension schemes this could be a life-saver, for money not set aside to cover a hole in the pension fund is money available for investment. Further, any rise in share prices opens the rights issue route for companies seeking more capital. Taken as a whole the company sector is cash-rich but there will be individual firms which are not and no company now wants to be beholden to its bankers.

So does the rise in share prices really add to demand? Marchel Alexandrovich at Jefferies International has looked at this and notes that an ECB working paper in 2009 concluded that for the euro area at least, a 10% increase in net financial wealth increased consumption by 1.2%.

If that were replicated here it would be huge. The UK market is up more than 10% over the past year and that should in theory eventually double our rate of growth in consumption — eventually because we don’t know the lags. But whether or not it boosts consumption, common sense tells us that it will boost industrial confidence. For the UK, I suspect that a more important determinant of consumption is house prices. That ECB study calculated that changes in house prices in the euro area had a very small impact on consumption but that might just be another way UK behaviour differs from that of our Continental cousins.

Indeed our relationship with property is surely much closer to that of Americans and one of the really important issues this year will be whether rising confidence among US home-owners will offset concern about the handling of the fiscal deficit.

We don’t know what Congress will do but we can be pretty sure that the recovery in home prices evident since last summer will be sustained. The Fed will keep the taps open and the resulting historically cheap mortgage rates will see to that.

US house prices are still fairly high by long-term historical standards — as indeed are ours — but they do seem to have bottomed out over the past 18 months and since last summer have been nudging up more or less everywhere.

My feeling here is that the US housing market will be the single most important determinant of how the world economy performs this coming year. It is not just that US consumption is 70% of the world’s largest economy. The collapse of the world financial system began because of a collapse in US house prices. So a recovering US housing market not only helps maintain global demand; it also helps to reduce the property overhang still depressing the world’s banking system.

To be clear, there are lots of reasons to be cautious about the present uplift in financial markets. There are a host of things that can go wrong. These include mismanagement of the US fiscal situation, an economic collapse across southern Europe, Germany back in recession and so on.

Our own situation here is precarious, for we have made only modest progress in controlling our deficit and are stuck, unable to reduce it further if growth does not pick up. More generally the rise in asset prices depends on the various central banks continuing to pump up their respective economies, which for the time being they will, but which will create the long-term danger of higher, maybe much higher, inflation.

But to focus on the fragility of the recovery in asset prices is to ignore the impact this recovery has on real confidence, real demand and hence on real growth. We are not yet in a virtuous circle but if this market recovery is sustained we will be in much less danger of slipping into a vicious downward spiral than we seemed a few months ago.